2 Decision Making Economic - Pearson
2
Economic
Decision Making
G
ood fortune has come your way. After several weeks of interviewing,
you have received job offers from three firms. The offers differ greatly,
which leaves you quite confused. You have made this list of the offers:
1. Large national firm, $12 per hour starting wage, life insurance and
dental benefits paid by the company, a two-week paid vacation
each year, and potential for rapid advancement.
2. Small local firm, $20 per hour starting wage, life insurance and
dental benefits available but you must pay the premiums, a twoweek paid vacation each year, share options and pension plan
benefits, and potential for advancement.
3. Regional firm, $15 per hour starting wage, full life insurance and
dental benefits, one-week paid vacation, good pension plan, and
moderate advancement potential.
Will you consider the short run or the long run for this decision? Which
offer provides you with the most today and which one the most over
the next five years? What is the real economic value of the benefits?
Aside from the monetary considerations, do you like the work you will
perform in each position and the people with whom you will work?
How do you organize your thoughts to make this decision?
Regardless of the form of organization or the business activity,
success in the world of business¡ªsometimes even survival¡ªdepends
on making wise economic decisions. A key ingredient is an understanding of the decision-making process itself. Because economic
decision making relies heavily on accounting information, it is crucial
for that information to be useful to economic decision makers.
Life is a never-ending sequence of decisions, some very complex
and others relatively simple. Because we cannot know the future, we
strive to reduce uncertainty in any decision by collecting as much
information as possible. We designed this chapter to help you learn a
logical decision-making process. ¡ö
LEARNING
OBJECTIVES
After completing your work on this chapter, you should be able to do the
following:
1. Explain the concepts of extrinsic and intrinsic rewards, sacrifices, and
opportunity costs as they pertain to decision situations.
2. Describe the two types of economic decision makers and explain the basic
differences between management accounting and financial accounting.
3. List the three questions all economic decision makers attempt to
answer and explain why these questions are so important.
4. Describe the importance of cash as a measure of business success or failure.
5. Define accounting information and distinguish it from accounting data.
6. Describe the qualitative characteristics of useful accounting
information and apply them in decision-making situations.
7. Explain the difference between reality and the measurement of reality.
8. Apply the criteria for revenue and expense recognition under the cash
basis of accounting to determine periodic net income.
9. Apply the criteria for revenue and expense recognition under the
accrual basis of accounting to determine periodic net income.
WHAT IS DECISION MAKING?
Decision making is the process of identifying alternative courses of action and selecting an appropriate alternative in a given decision situation. This definition presents two important parts:
1. Identifying alternative courses of action means that an ideal solution may not
exist or might not be identifiable.
2. Selecting an appropriate alternative implies that there may be a number of
appropriate alternatives and that inappropriate alternatives are to be
evaluated and rejected. Thus, judgment is fundamental to decision making.
Choice is implicit in our definition of decision making. We may not like the alternatives available to us, but we are seldom left without choices.
Rewards and Sacrifices: The Trade-off
In general, the aim of all decisions is to obtain some type of reward, either economic or personal. Reward requires sacrifice. When you made the decision to
attend college or university, for example, you certainly desired a reward. What was
the sacrifice?
Chapter 2
Economic Decision Making
33
Discussion Questions
2¨C1. What reward or rewards do you hope to obtain by attending college
or university?
2¨C2. What sacrifices are you personally making to attend college or
university ?
opportunity cost The
benefit or benefits forgone
by not selecting a particular
alternative. Once an alternative
is selected in a decision
situation, the benefits of all
rejected alternatives become
part of the opportunity cost of
the alternative selected.
cost/benefit analysis
Deals with the trade-off
between the rewards of
selecting a given alternative
and the sacrifices required
to obtain those rewards.
Think of some things you cannot do because you are attending college. Some
sacrifices cannot be measured in dollars (such as loss of sleep, lack of home-cooked
meals, and loss of leisure time). Some, however, can be measured. Suppose that
instead of attending college you could work full time and earn $15,000 a year.
Attending college, therefore, costs you that $15,000, in addition to what you pay for
tuition and books. We call the $15,000 an opportunity cost of making the decision to
attend college. An opportunity cost is the reward we forego because we choose a
particular alternative instead of another. Most decisions include opportunity costs.
Decision makers want the reward or benefit from a decision to be greater than
the sacrifice or cost required to attain it (see Exhibit 2¨C1). Examining the relationship between rewards and sacrifices is known as cost/benefit analysis. In a condition of absolute certainty, in which the outcome of a decision is known without
doubt, cost/benefit analysis provides a certain outcome. Unfortunately, absolute
certainty rarely, if ever, exists.
In examples that accountants use to describe the trade-off between rewards
and sacrifices, money is usually the reward. Money is an extrinsic reward, meaning
that it comes from outside ourselves and is a tangible object we can acquire. An
intrinsic reward is one that comes from inside ourselves. When you accomplish a
difficult task, the intrinsic reward comes from the sense of satisfaction you feel. An
old adage says, ¡°The best things in life are free.¡± Not so! Anything worth having
requires sacrifice.
Exhibit 2¨C1
Cost versus Benefit
Cost
Benefit
Discussion Questions
2¨C3. What is the one thing you desire most from life? What sacrifices
must you make to obtain it?
2¨C4. What sacrifice does a business owner make when purchasing
machinery for the production plant?
2¨C5. What benefit does the owner derive from the sacrifice to purchase
the machinery?
34
Chapter 2
Economic Decision Making
ECONOMIC DECISION MAKING
internal decision makers
Economic decision makers
within a company who make
decisions for the company. They
have access to much or all of
the accounting information
generated within the company.
external decision makers
Economic decision makers
outside a company who make
decisions about the company.
The accounting information
they use to make those
decisions is limited to what the
company provides to them.
Economic decision making, in this book, refers to the process of making business decisions involving money. All economic decisions of any consequence require the use
of some sort of accounting information, often in the form of financial reports.
Anyone using accounting information to make economic decisions must understand the business and economic environment in which accounting information is
generated, and they must also be willing to devote the necessary time and energy
to make sense of the accounting reports.
Economic decision makers are either internal or external. Internal decision
makers are individuals within a company who make decisions on behalf of the
company, while external decision makers are individuals or organizations outside
a company who make decisions that affect the company. Exhibit 2-2 illustrates
some decisions made by internal and external decision makers.
EXTERNAL
DECISION MAKERS
Exhibit 2¨C2
External vs. Internal
Decision Makers
Bankers
INTERNAL
DECISION MAKERS
Loan
Customers
Invoice
Investors
Make
Decisions
About
a Firm
Shares
Make
Decisions
for
the
Firm
Marketing
Sales Campaigns
Accounting
Financial Information
Production
What to Produce
Vendors
Personnel
Who to Hire
Purchase
Order
Internal Decision Makers
Internal decision makers decide whether the company should sell a particular
product, whether it should enter a certain market, and whether it should hire or
fire employees. Note that in all these matters, the responsible internal decision
maker makes the decision not for himself or herself, but rather for the company.
Depending on their position within the company, internal decision makers
may have access to much, or even all, of the company¡¯s financial information. They
do not have complete information, however, because all decisions relate to the
future and always involve unknowns.
External Decision Makers
External decision makers make decisions about a company. External decision makers decide whether to invest in the company, whether to sell to or buy from the
company, and whether to lend money to the company.
Chapter 2
Economic Decision Making
35
Unlike internal decision makers, external decision makers have limited financial information on which to base their decisions about the company. In fact, they
have only the information the company gives them¡ªwhich in most cases is not all
the information the company possesses.
Discussion Questions
2¨C6. Identify a particular company (large or small). Who do you think are
considered internal and external economic decision makers of the
company?
2¨C7. For what reasons do you think a company would withhold certain
financial information from external parties?
2¨C8. Is it ethical for a company to limit the information available to
internal decision makers? External decision makers?
management accounting
The branch of accounting
developed to meet the
informational needs of internal
decision makers.
financial accounting
The branch of accounting
developed to meet the
informational needs of
external decision makers.
cash flow The movement of
cash in and out of a company.
net cash flow The difference
between cash inflows and
cash outflows; it can be either
positive or negative.
The decisions made by internal and external decision makers are similar in
some ways, but so different in other ways that the accounting profession developed two separate branches of accounting to meet the needs of the two categories
of users. Management accounting is not constrained by GAAP and generates
information for use by internal decision makers, whereas financial accounting is
constrained by GAAP and generates information for use by external parties.
What All Economic Decision Makers Want to Know
Although internal and external parties face different decision situations, both
attempt to predict the future, as do all decision makers. Specifically, all economic
decision makers attempt to predict future cash flow¡ªthe movement of cash in and
out of a company. So one of the major objectives of financial reporting is to provide
helpful information to those trying to predict cash flows.
The difference between cash inflows and cash outflows is net cash flow.
Positive net cash flow indicates that the amount of cash flowing into the company
exceeds the amount flowing out of the company during a particular period. For
example, a company that collects $1,000,000 during a period when it pays out
$950,000 has a positive cash flow of $50,000. Negative net cash flow indicates that
the amount of cash flowing out of the company exceeds the amount flowing into
the company during a particular period (see Exhibit 2¨C3).
Exhibit 2¨C3
Cash Flow
Cash inflow
$1,000,000
Cash outflow
$950,000
Positive net cash flow
$50,000
Cash inflow
$ 500,000
Cash outflow
$575,000
Negative net cash flow
$75,000
All economic decisions involve attempts to predict the future of cash flows by
searching for the answers to the following three questions:
36
Chapter 2
Economic Decision Making
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